Analysis of the 2005-06 Budget Bill

Legislative Analyst's Office
February 2005

In 2003-04, 682,000 students age 22 and under were enrolled in special
education programs in California, accounting for about 11 percent of all
K-12 students. Special education is administered through a regional planning
system consisting of Special Education Local Plan Areas (SELPAs). In 2003-04,
there were 116 SELPAs.

Figure 1 displays the amounts proposed for special education in 2004-05
and 2005-06. The Governor's budget proposes total expenditures of $4.4 billion
for special education in 2005-06, an increase of $215 million, or 5.1 percent.
Under this proposal, General Fund support for special education would increase
by $135 million or 4.9 percent. The budget proposes sufficient funding
to accommodate a projected 0.79 percent increase in the number of students
in the state, a 3.93 percent cost-of-living adjustment (COLA), and an
augmentation of $25 million to base SELPA funding levels.

Our review of the 2005-06 proposed budget identifies several major issues:

Technical Budgeting Issues. There are two
significant technical issues with the proposed special education budget.
Addressing these issues would increase the Legislature's fiscal flexibility
in the budget year.

Mental Health Services. The Governor's
proposal does not provide a long-term solution regarding the provision of
mental health services for special education students.

Incidence Adjustment. The budget includes
no proposal for updating the special education incidence adjustment, despite
the fact the adjustments are based on data that is now eight years old.

The state's special education budget is supported from three sources: local
property tax collections, federal special education funds, and the state General
Fund. Together, the state uses these three sources to maintain a system of
relatively uniform per-pupil SELPA funding levels.

The Department of Finance (DOF) developed the 2005-06 special education
budget by adding funding for the anticipated level of growth in the student
population in 2005-06, a COLA, and other adjustments to the 2004-05 special
education budget. As part of that process, DOF revised the 2003-04 and 2004-05
figures to reflect more recent estimates of program expenditures and growth in
the student population. These base adjustments are important, as they can have a
significant effect on the 2005-06 budget proposal.

We have identified two major technical budgeting issues with the 2005-06
special education budget that could reduce program costs by $61 million.
First, we propose an alternative method for calculating the amount of federal
funds that can be counted as an offset to the General Fund. Second, we identify
technical problems in the special education budget that would, if corrected,
generate significant General Fund savings.

We recommend the Legislature adopt an alternative calculation for
complying with new federal supplanting rules. This recommendation would reduce
General Fund special education costs in 2005-06 by $9.9 million.

Congress reauthorized the federal special education law in 2004. One new
provision in the act prohibits states from using federal funds to pay for
"state-law mandated funding obligations to local educational agencies,
including funding based on student attendance or enrollment, or inflation."
It appears the new language is designed to prohibit states from using federal
funds to supplant state funds for normal budget increases such as growth and
COLA.

California has used federal special education funds in ways that the new
federal law appears to prohibit. The 2004-05 Budget Act, for instance,
used $124 million in new federal funds to pay for growth and COLA for the
entire special education budget—including the state's share. Using federal
funds in this way reduced the state's cost of special education. It appears,
however, that the new federal law prohibits this from occurring in the future.

The budget proposes to comply with the new federal restriction, proposing to
use $38.1 million of the increase in federal funds to offset growth and
COLA and $24.8 million to augment the base program. We think the budget's
new supplanting calculation would not work, for two reasons. First, despite the
administration's intent to comply with the new federal law, the proposal uses a
portion of the federal funds to pay for state growth adjustments—something
specifically prohibited by the new federal rule. Of the $38.1 million in
new federal funds the budget would use to pay for prior-year adjustments, we
identified $5 million in budget increases that fall into the category of
"state-law mandated funding obligations." Second, we think the
calculation would disadvantage the state in 2006-07 and beyond. The budget's
proposed new supplanting formula works for only one year—in future years the
state likely would have to pass through to SELPAs all new federal funds in the
form of program augmentations.

We think there are simpler options for complying with the new federal
supplanting rules that would continue to allow the state to satisfy the new law
but also not disadvantage the state over the longer run. Our proposal
accomplishes this goal by separating the state and federal funding for budgeting
purposes. The state would be responsible for providing growth and COLA
adjustments on the portion of special education funds supported by state and
property tax funds. The federal government would provide funding for growth and
COLA increases on the portion support by federal funds. Any increase in federal
funds above the level needed for growth and COLA would be used for statewide
program augmentations. Any federal increase below that level would mean that
SELPAs would not be fully compensated for the effects of growth and inflation.
Under this proposal, only $14.9 million must be passed through to increase
special education funding—$9.9 million less than proposed in the
Governor's budget.

In sum, we recommend the Legislature adopt our alternative methodology for
budgeting special education federal funds at the state level. Our proposal
provides a simpler, more straightforward way to comply with the intent of the
new federal law than the calculation proposed in the budget. In addition, our
methodology would generate $10 million in General Fund savings. The purpose
of our proposal, however, is to comply with the new federal law while protecting
the state's system of local grants—not to generate short-term savings. Below,
we discuss our proposal for the use of the $9.9 million and the $14.9 million
in "pass-through" funds.

We recommend the Legislature make two technical corrections in the
proposed special education budget that will free more than $36 million in
funds for other special education and Proposition 98 programs.

As noted above, the DOF revised the 2003-04 and 2004-05 estimates of special
education spending in the development of the 2005-06 proposed budget. Our review
found two major technical problems with the adjustments to the 2003-04 and
2004-05 budgets:

Lower Estimated 2003-04 Growth. The
Governor's budget fails to recognize $16.1 million in savings resulting
from the revised estimate of student growth in 2003-04, which is
significantly lower than assumed in the 2003-04 Budget Act. Because
of federal "maintenance of effort" rules, these funds must be
spent on special education.

Overbudgeting the New Licensed Children's
Institution (LCI) Formula. The 2005-06 budget inadvertently assumes
a $19.2 million increase in 2004-05 special education costs of students
residing in LCIs compared to the level included in the 2004-05 Budget Act.
This technical error results in overbudgeting the LCI formula by $20.2 million
in the 2005-06 budget.

We recommend the Legislature correct these technical errors, for a total
savings of $36.3 million.

We recommend the Legislature spend $61 million resulting from our
recommendations for various special education programs in 2004-05 and 2005-06.

Figure 2 summarizes the impact of the technical budgeting
recommendations made above. The figure includes the $24.8 million in funds
discussed in our recommendation for an alternative supplanting calculation. It
also contains the $36.3 million in savings from our recommendation to
correct two technical errors in the special education budget. This brings total
funds available from our recommendations to $61.1 million.

Figure 2 also shows our suggested uses of the $61 million. The
2003-04 savings are one-time in nature and, therefore, should be spent on
one-time activities. The remaining funds represent 2005-06 funds that may be
used for any special education purpose. Our proposal also is shaped by issues
raised by the Governor's proposed special education budget for 2005-06.
Specifically, we recommend the Legislature use the savings as follows:

$42.8 million to increase support for mental health
services for special education students. This would use most of the ongoing
funding that is available from our savings recommendations. We discuss this
issue further below.

$4.4 million ($2.2 million in 2004-05 and $2.2 million
in 2005-06) to add to the LCI formula a class of group homes that was
inadvertently excluded by the enabling legislation. We discuss this issue
further below.

$13.9 million in 2003-04 funds would be distributed
to SELPAs in a per-pupil block grant that could be used for any local
purpose. Federal MOE rules require the state to spend these funds for
special education. By using the funds as a one-time block grant, the
Legislature would honor the federal rules but not permanently increase
special education funding.

We recommend the Legislature eliminate two county mental health
mandates. We further recommend the Legislature provide a total of $143 million
in state and federal funds to support Special Education Local Plan Areas costs
of providing mental health services to special education students.

Federal law requires schools to provide mental health services to help
special education students benefit from educational services. In practice,
mental health services for this population range from short-term counseling on
an outpatient basis to long-term psychiatric therapy for students in residential
care facilities.

In the early 1980s, the state shifted responsibility for providing more
intensive mental health services from school districts to county mental health
agencies. This shift created a reimbursable state-mandated program that, by
2002-03, resulted in annual county claims of $123 million. This mandated
program is often referred to as the "AB 3632" program, in
reference to its enabling legislation. In 1996, the state also shifted
responsibility for mental health services of students placed in out-of-state
residential facilities to county mental health agencies. Claims for these
out-of-state students totaled $22 million in 2002-03, resulting in total
claims for the two mandates of $145 million.

As with most other education mandates, the state deferred payment of the two
mandates in the 2004-05 Budget Act—that is, the mandate was kept in
place but no direct county reimbursement was provided in the Department of
Mental Health's budget. To help pay for these mental health services, however,
the special education budget included $69 million in federal funds for
distribution to county mental health agencies. These funds provide partial state
reimbursement for county AB 3632 costs. An additional $31 million from the
General Fund was appropriated to support mental health services provided by
SELPAs.

The Governor's budget proposes to suspend the two mandates in 2005-06. The
passage of Proposition 1A in fall 2004 requires the state to either fund or
suspend local government mandates each year. Suspending the mandate frees local
government from the service requirement for 2005-06.

The budget proposes no county funding for AB 3632 or out-of-state students.
Because state law would not require county mental health agencies to provide
services to special education students in 2005-06, responsibility for services
would fall to SELPAs and school districts. (This is because federal law requires
these services to be provided to special education students.) The special
education budget proposes to continue the 2004-05 funding set-asides for mental
health services ($69 million in federal funds for counties and $31 million
from the General Fund for SELPAs). The administration has not stated its
long-term intent for funding the two mental health mandates.

We recommend the Legislature permanently assign this program responsibility
to SELPAs, for several reasons. A one-year suspension, as proposed in the
Governor's budget, would place SELPAs in a form of limbo: Does the proposal
represent a permanent shift of responsibilities to education or would the
mandates be funded in the future (thereby shifting program responsibility back
to county mental health agencies)? A one-year suspension, therefore, would
inhibit SELPAs from making the significant local administrative changes they
would need to make if the shift in responsibilities is intended to be permanent.

In addition, the proposal muddies what have been clear lines of local
responsibility. By continuing to funnel $69 million in special education
funding to county mental health agencies, for instance, the budget proposal
gives SELPAs financial responsibility for services, but does not give them
administrative or policy control related to the services provided.

Finally, we recommend the Legislature make the shift of responsibility
permanent because we are convinced that, by assigning full responsibility for
these services to education, the state would foster a more efficient and
effective service delivery system of mental health services to students. We
discuss these issues further below.

Education Would Have Incentives to Provide Services Efficiently. In
our view, the shift in responsibilities would result in a more efficient system
primarily because educators would have strong incentives to be a "prudent
purchaser" of services. Under the existing reimbursement system, educators
and county mental health agencies have incentives to increase the state's
mandated costs. Educators have the incentive to shift all mental health costs to
the county agencies—including the cost of services that remained education's
responsibility after the passage of AB 3632. County mental health agencies have
the incentive to include all mental health services needed by students under the
mandate—even if they are not required under federal law. In addition, by
reimbursing 100 percent of a county's program costs, the system also
reduces pressure on county agencies to limit the unit cost of services.

Recent audits by the State Controller's Office (SCO) confirms our view that
the mandate reimbursement system encourages counties to inflate the actual cost
of providing required mental health services to special education students. For
instance, an audit of Los Angeles County's AB 3632 claim for services provided
from 1998 through 2001 disallowed 21 percent, or $8.8 million, of the
county's charges. These costs were disallowed because the county charged the
state for (1) services that were not covered by the mandate, (2) services that
were funded by other programs, (3) offsetting funding that was not identified,
and (4) costs associated with overbilling and data entry errors. The county
concurred with the SCO findings. Audits of other county AB 3632 claims show
similar problems.

Placing SELPAs in charge of mental health services would strengthen local
incentives for the efficient use of state mental health funds. By adding funding
for these services into base special education grants, SELPAs would have the
resources needed to provide mental health services directly or through county
mental health agencies or other contracting entities. The SELPAs, however, would
have the incentive to keep these costs to a minimum—any funds not needed for
mental health services could be used to pay for other special education
services. As a result, by giving SELPAs a reasonable amount of funds to pay for
mental health services, we think the state would establish the incentives needed
for a more efficient program structure.

Shift Could Improve Effectiveness of Services to Students. Returning
responsibility for mental health services to SELPAs also would result in a more
effective delivery system if it encouraged educators to increase the use of
less-intensive preventive mental health services. As noted above, one
consequence of AB 3632 is that the program creates an incentive for educators to
shift as many mental health costs to county agencies as possible. In legislative
discussions on AB 3632 last spring, county mental health agency staff expressed
the belief that many schools fail to provide the early intervention services
that remained the responsibility of education even after AB 3632 was enacted. To
address this concern, the Legislature included $31 million in the 2004-05
special education budget to require SELPAs to provide more early
intervention services.

Placing SELPAs in charge of mental health services, however, would encourage
schools to recreate the capacity to provide these intervention services. Early
intervention often is more cost effective. The proposal to shift responsibility
back to education, therefore, may encourage educators to intervene earlier when
behavioral problems can be treated with less intensive services. This would be
good for students (avoiding the need for more intensive services) and it would
represent another way that changing the local incentives for mental health
services would benefit the state.

For the above reasons, we recommend that the Legislature eliminate the
existing mental health mandates on counties. Federal law requires school
districts provide these services. By eliminating the state mandate on counties,
our recommendation has the effect of returning these responsibilities to school
districts.

We also recommend the Legislature revise the proposed Budget Bill language
and add the full $100 million earmarked for mental health services into the
base special education funding formula. In addition, we recommend the
Legislature redirect $42.8 million more in funding to SELPAs for mental
health services (we discussed the source of these funds earlier in this
section). This would provide a total of $142.8 million to SELPAs for mental
health services in 2005-06. Based on past claims (and the magnitude of
disallowed county costs), we believe our proposal provides a reasonable amount
to allow SELPAs to pay for the needed mental health services.

We recommend the Legislature adopt trailer bill language to recognize
the special education costs for residents of a class of licensed children's
institutions that was inadvertently excluded from last year's trailer
legislation. Fixing this error would cost $2.2 million in both 2004-05 and
2005-06.

As part of the 2004-05 Budget Act, the Legislature revamped the
funding formula for the support of special education students who reside in an
LCI. In 2002-03, more than 50,000 K-12 students lived in an LCI (including
foster family homes or group homes) because the youth's family was unable to
provide needed care. The Department of Social Services licenses group homes
based on the services needed by youth living in each home.

Since the enactment of the new formula, however, the State Department of
Education (SDE) discovered that the trailer legislation inadvertently omitted a
class of group homes from the formula. Specifically, the formula failed to
include 129 community care facilities that serve disabled youth who are referred
by regional centers for the disabled. Adding these group homes to the new LCI
model increases costs by $2.2 million in both 2004-05 and 2005-06.

To correct for this oversight, we recommend the Legislature adopt trailer
bill language that adds the community care facilities to the list of group homes
used to distribute special education funds. We also recommend the Legislature
add $4.4 million ($2.2 million in one-time funds that must be spent on
special education programs for the 2004-05 costs and $2.2 million in
ongoing 2005-06 funds) to the special education budget to pay for costs
associated with the additional facilities.

We recommend the State Department of Education report to the budget
subcommittees before March 1 on the feasibility of assuming responsibility
for calculating the special education "incidence" adjustment.

The 2005-06 budget proposes $84 million to pay for the special education
"incidence" adjustment in 2005-06. State law calls for these
supplements to local apportionments as a way of acknowledging that, for a
variety of factors, some SELPAs experience higher costs than the typical SELPA.
The current adjustments were calculated in 1998 using 1996-97 cost data. Since
the factors underlying local cost profiles change over time, the existing
adjustments likely no longer reflect actual SELPA costs.

To update the adjustments, the Legislature required SDE to contract for a
study in 2002-03. This study was completed in the fall of 2003. Despite
significant data problems, the study recommended a new set of incidence
adjustments. The data problems, however, were so severe that they clouded the
legitimacy of these new adjustments in the eyes of many SELPA administrators.
The credibility of the incidence adjustments is very important, as the
adjustments are designed to increase the fairness of the state's system of
uniform base special education grants.

The study identified data quality as a prime concern. The SDE maintains a
comprehensive special education database that provided the data for the 1998 and
2003 incidence factor studies. According to SDE, changes to the database made in
2001-02 resulted in local coding errors that reduced the accuracy of the data.
The department believes these problems have been corrected with the 2002-03
data.

The study also suggested that the state update the incidence adjustments
annually in order to avoid "radical changes in funding for some SELPAs"
that may occur if the adjustments are reassessed only every five years. Indeed,
changes to the adjustments identified in the 2003 study were so large that the
study recommended a phased approach to implementing the new adjustments. The
study suggests that a more frequent calculation of the adjustments would ease
transition problems.

In our view, the problems with the 2001-02 data require updating the
incidence adjustments. This would be no small task, however. The study presents
a series of technical and policy issues that have to be resolved each time the
adjustment is recalculated. In our discussion on this issue, we asked SDE to
assess the feasibility and cost of assuming responsibility for this task. At the
time this analysis was written, the department was in the process of determining
what resources would be needed to replicate the study.

In our view, the long-term viability of the incidence factor rides on the
department's capacity to update the adjustment. The current reliance on the 1998
adjustments can no longer be defended given the many changes to SELPA costs that
have occurred over the past eight years. In addition, the use of outside
contractors to recalculate the adjustment is expensive and
time-consuming—particularly if the Legislature would like to update the
adjustment more often than every five years. If the department does not believe
it can reasonably develop the capacity to assume this responsibility, the
Legislature will need to either (1) consider eliminating the adjustment or (2)
spend about $150,000 each year or two to update the adjustment.

To assist the Legislature in assessing its options for the long-term
viability of the incidence adjustment, we recommend SDE report to the budget
subcommittees on the costs and feasibility of the department assuming
responsibility for calculating the special education incidence adjustment.